What's the biggest risk in China private equity investing? Depends who you're asking. If you ask Limited Partners, the people who provide all the money that PE firms live off, you will often hear a surprising answer: turnover at PE firms. Nowhere else in the PE and VC world do you find so many firms where partners are feuding, quitting or being thrown off the bus.
American institutions - including Fidelity, Goldman Sachs, as well as many of the largest family offices - are some of the largest investors in China private equity. This instability in their China investing is a drag on overall performance.
A partnership at a PE firm was meant to be a long-term fiduciary commitment. In China, it rarely is. The result is billions of dollars of LP money often gets stranded, and possibly wasted. That's because when a partner leaves, it often creates a bunch of orphaned investments. The departing partner is generally the only solid link between the PE firm and the investee company. Everyone left behind is harmed - the PE firms, the companies they invest in, and the LPs whose money is trapped inside these deals.
As the CEO one of Asia's largest and most professional LPs told me recently, "Before committing to a new China fund, we spend more of our time trying to figure out how the partners get along than just about anything else. Will they hang on together through the life of the fund? We know from experience how damaging it is when partners fall out, when key people leave. We know turnover can mean we lose everything we've invested. And yet, we still often get stung."
In my nearly-twenty years in and around the PE and VC industry in the US, Europe and Asia, I've never seen anything quite like what happens here in China. A quick look through my Outlook contacts reveals that almost half the PE partners I know working in China have changed firms in the last five years. One reason you don't see this elsewhere is that partners expect to earn carried interest on the deals they've made. If they leave, they forgo this.
Carry is a kind of unvested pay. On paper, it's often quite sizable, and should represent the majority of a PE partner's total comp, as well a kind of golden handcuff. The only reason for partners to leave is they believe they won't get any of this money, either because of failed deals or, more commonly, large doubts that the head partner, the person running the firm, will share the rewards from successful deals.
Most China PE firms are partnerships in name only. There is usually one top dog, usually the founder and rainmaker. This person can unilaterally decide who stays, who goes, who gets carry and who gets a lump of coal. Top Dog tends to treat partners like overpaid, somewhat undeserving hired hands.
So, why have partners at all? Often it's because LPs insist on it, that they want PE and VC firms in China to be structured like those elsewhere. The business card says "Partner" but the attitude, expectations and level of commitment say "Employee".
Senior staff (VPs, Managing Directors) also frequently depart. In the US, you don't often see that much, since these are the people in line to become partners, which is meant to be the crowning achievement of a long successful career in the trenches. They leave because they don't believe they'll be promoted, or if they are, that they'll see any real change in their current status as wage-earners.
At a party celebrating a recent IPO of a PE-backed Chinese company, I ran into the PE guy who led the original investment, did all the heavy lifting. He had since left and joined another firm. He laughed when I asked why he would leave before the IPO, with his old firm certain to earn a big profit on his deal. "I don't know who will get the carry, but I was sure it wouldn't include me," he explained.
Partners jump ship most often because someone is offering a higher salary, a higher guaranteed amount of pay. Their new firm will usually also offer them carry. Both sides will negotiate fiercely over the specific terms, what percent with what hurdle rate. And yet, more often than not, it seems to be a charade.
From day one, the new partners may already thinking about their next career move, how to trade up. Emblematic of this: here in China, when PE partners join a new firm, they almost always refer to it as "joining a new platform". Note the choice of words: platform, not firm.
The LPs - and I speak to quite a lot of them - acknowledge, of course, that there are other big risks in China, that individual investments or even a whole portfolio turns sour. But, this is a risk inherent in all PE investing everywhere. High partner turnover is not.
If you're interested, you can click here and read the email exchange I had recently with a newly-departed partner at one of China's better-known VC firms. As I write there, I hate to sound like a scold. I know PE partners also want to earn a good living, and should work where they are happiest and best compensated. But, China's PE industry serves a deeper economic purpose and holds in trust the assets of both investors and companies. "Looking out for Number One" should not be the only career goal of those working in senior levels in the industry.-